Description

Hipgnosis Songs Fund is a London-traded Guernsey Registered Investment Company. It is effectively a closed-end fund that owns various music rights to 65,413 songs on which it receives royalty payments. It trades at 74.3 P per share. The official NAV was 118.63 P per share in March 2023. Effectively, this trades at a 38% discount to the official NAV.

Hipgnosis was previously written up on VIC here. The exit strategy mentioned there is interesting because I think it could still work out that way in the long term although the numbers would likely be a little bit less favorable. In the short term, things didn't really work out because the fund overreached and was caught off-guard by rapidly rising rates. This sets up an opportunity today to acquire what I think are correctly identified as attractive assets at a very attractive price. 

As of 31 March 2023, the Company had deployed approximately $2.2 billion in total buying music rights in recent years. The current market cap is £882.73m. There is £463m of debt.  

The trust is currently very unpopular with its investor base. As recognized in this VIC write-up, it is effectively a yield play. The last dividend got scrapped, and performance has been horrible. This is most likely due to higher interest, but the company also gorged on floating-rate debt when things were awesome. Borrowing at ~3% and buying music royalties at 8% rate or so is pretty good business. 

Most egregiously, the company announced a transaction selling part of its assets to a combination of management/Blackrock. Officially, assets would be sold at a discount of 17.5% to fair value but activist AVI estimates the discount is more like 30% in practice. Since the announcement, the share price has declined by around 20% and the fund is trading at a 38% discount to NAV. I believe the transaction is likely off the table. If it were to proceed at the activists estimated discount to net asset value it would still help to close the current gap to net asset value. 

Why did the fund announce this panicky transaction, slashed dividends and made other moves that appear poorly thought through?  

I think they hit or were very close to hitting some covenants on their credit facility regarding interest rate coverage. 

Net debt decreased to $562.0 million on 31 March 2023. The company is paying SOFR + 2 on the floating rate debt which is 5.31 + 2 = 7.31%. At the current rate the company is facing interest expenses of $41 million per year. This floating rate debt isn't as dangerous as it appears, as the company has also fixed almost all of the amount drawn through 2026/2027 with a hedging transaction. From annual report: 

Since 3 January 2023, $340 million has been hedged

for the duration of the RCF (until 30 September 2027) at

a fixed rate of 5.67% (including debt margin); a further

$200 million is hedged until 3 January 2026 at a fixed

rate of 5.89% (including debt margin). The balance

remains unhedged to provide flexibility.

The latest company release also states an amendment has cured the breach. 

The company also hit a short-term challenge (that it should have seen coming) where outperformance on certain Catalogues (a good thing for the future), triggered an additional Catalogue performance bonus provision of $43.8 million. 

EBITDA for the year ended 31 March 2023 decreased by 10.1% year-on-year to $117.7 million. Over 2022, this was still $130.9 million.(mostly because of a one-time cash charge). 

The fund has been doing things that don't make much sense to me in the last few years on the financial side. Buybacks were announced, Floating credit was taken out(when Fed is saying its raising all the time), later fixing the credit through hedges for just a few years, scrapping the dividend, wanting to sell part of the portfolio(to a combo of management/Blackstone), announce a buyback program at the same time :S 

The asset sale is very unpopular with shareholders and resulted in an activist response from Asset Value Investors.

Today, the company announced a strategic alternative review and my read is that it has become clear to management they're not going to get the asset sale through shareholders. From the announcement: 

This decision follows extensive engagement over recent weeks with shareholders in light of the forthcoming Continuation Resolution and First Disposal Resolution. These meetings highlighted a continued belief in the Company’s portfolio and growth prospects of the asset class as well as the need for changes by the Company in order to deliver value for shareholders.

Officially, the company still recommends shareholders to vote for the merger but AVI (activist) believes this is to avoid triggering a $6.6 million termination fee. If the transaction gets voted down this doesn't have to be paid.  

It looks like the Chair, and likely the board is going to get thrown out:

The Board has commenced the process to identify a new Chair for the Company and has appointed an executive search firm, with a view to announcing a new Chair at the earliest opportunity. As mentioned in the Company’s recent annual results and following individual discussions with each Director, a timetable has been set for the phased retirement and, if appropriate, replacement of the Directors in place since IPO.

Investment Adviser is a little less certain as they are somewhat entrenched but their head appears on the chopping block as well:

In light of the Strategic Review, the Board has looked at making changes to the Investment Advisory Agreement: - It has considered serving notice on the Investment Adviser to terminate the Investment Advisory Agreement, but concluded that it is not currently in shareholders’ interests to do so, as it would be an event of default under the Revolving Credit Facility if the Investment Advisory Agreement terminates in circumstances where a new investment adviser has not been approved by lenders. The Investment Advisory Agreement can be terminated, other than for cause, by the Company on  not less than 12 months’ notice, with an additional one-time termination fee equal to one year’s advisory fee calculated on NAV as at the termination date. - The Board has asked the Investment Adviser to remove the clause in the Investment Advisory Agreement related to the call option entitling it to acquire the Company’s portfolio on termination of its contract, which the Investment Adviser has declined to accept. 

The fees aren't egregious with a ~1% base fee(in practice a bit lower). There is also a performance fee of 10% subject to cap, hurdle rate and high watermark. The performance fee can be paid mostly in shares. Removing them isn't necessary for this investment to work IMHO although it probably wouldn't hurt.  

The PR today also said that the Company's lenders have agreed to amendments to the Revolving Credit Facility to return the Company to compliance with the Fixed Charge Cover Ratio covenant.

The company has a very credible path to deleverage and to extend the debt further out. At current paid interest rates and before cutting expenses, there should be sufficient cash flow to generate $80-$100 million in free cash flow (the performance bonus for songwriters goes away) per year. This means the fund trades at a 8%-10% free cash flow yield. The free cash flow should go up to at least $140 million as debt is paid. The current stock price effectively offers a 14% future free cash flow yield. This is especially attractive because in essence a trust with music royalties and low debt isn't very risky at all. It should generate stable recurring cash flows and exhibit relatively low volatility. This is currently not the case but IMHO this can be fixed.   

Music royalties tend to perform through recessions and tend to follow inflation. I see many arguments that the share price is falling due to higher interest rates, but that only makes partial sense to me. Interest rates are rising because we're in an inflationary environment. In such an inflation environment, protected cashflows should command a larger premium than traditional fixed income. What I think hurt the fund is its floating rate debt, but further inflation is beneficial with that fixed.

1) I believe the shares should recover some ground on today's announcement

2) If the Blackrock deal is shut down this should help the company re-rate

3) There's potential for an extended activist-driven cleanup (i.e. removing an obnoxious buyout option by management) that should also help with the rerate. Chair is on the way out. Board and investment manager are under siege. 

Catalyst

26 October 2023 shareholder vote